Download Bonds: Fed Watching—and Opportunity Hunting—in 2015

FIXED-INCOMEINSIGHTS
Bonds:FedWatching—andOpportunityHunting—in2015
December22,2014
ZaneE.Brown
Partner,FixedIncomeStrategist
WiththeU.S.FederalReservepoisedtodominatethefinancialheadlinesin2015,
whichsegmentsofthefixed-incomemarketmightbemostattractive?
InBrief
What can U.S. fixed-income investors expect as 2015 unfolds? Let’s look at two key areas of
concern:
1)U.S.economy—Jobsgrowth,andimprovementsincommercialandconsumerlending,signalthat
U.S.economicgrowthisimprovingandpotentiallyself-sustaining.
2)Fedpolicy—WhilethemedianprojectionfromU.S.FederalReservepolicymakerscallsforthefed
fundsratetoincreaseto1.13%bytheendof2015,acumulativerateriseof0.50%to0.75%seems
moreappropriate,andmorelikely.
The key takeaway—Within fixed income, convertible securities, high yield, and the lower tiers of
investment-grade debt seem positioned to perform better than lower-coupon, interest ratesensitive,high-qualitysecurities.
In looking toward the prospects for markets and the economy in 2015, one cannot help but focus
squarelyontheU.S.FederalReserveanditseffortstobringinterestratestoward“normal”levels.
Persistentjobsgrowth,increasedbanklending,andtheconsumption-friendlybenefitsofastronger
dollarandloweroilpricescreateanenvironmentidealfortheFedtobeginadjustingmonetarypolicy
towardnormalinterestrates.
TheFed’smovestowardthisgoalseemlikelytoberestrainedbylowinflation,afearofhandicapping
U.S.expansion,andslowglobalgrowth.Ariseinlonger-terminterestratesalsocouldberestrained
bylowinflationandlowratesoncomparablematuritiesofgovernmentbondsinEuropeandJapan.
Even if interest rates were to rise only a portion of what the Fed expects, yields on high-quality,
interestrate-sensitivedebtwillbeaffectedmorethanthoseoflower-quality,economicallysensitive
securities. In a world starved for economic growth, yield, and currency security, U.S. investments
seempositionedtobenefit.Withinfixedincome,convertiblebonds,highyield,andthelowertiersof
investment-gradedebtshouldperformbetterthanlowercoupon,interestrate-sensitivehigh-quality
securities.
Let’stakeacloserlookatwhatinvestorsmayexpectas2015unfolds.
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EconomicBackground
Jobs growth, and the level of commercial and consumer lending, have been Fed focal points for
indicationsthatU.S.economicgrowthisimprovingandpotentiallyself-sustaining.The2014nonfarm
payrolls numbers from the Bureau of Labor Statistics suggest the Fed’s patience has been
rewarded. Jobs growth has averaged more than 240,000 per month for the first 11 months of the
year, compared with monthly averages of 194,000 and 186,000 for 2013 and 2012, respectively.
Although many jobs are temporary or low paying, improvement has been made in the number of
higher-payingjobs,includingmanufacturingandbusinessandprofessionalpositions.Towardtheend
oftheyear,slightincreasesincompensationalsohavesurfaced.
In terms of lending, increases are evident among all key categories. According to the Fed,
commercial and industrial loans through November grew at a 12% pace in 2014, compared with
about 7% in 2013. Consumer loans were up at a 5% rate versus 3.5% in 2013. And real estate
lendingfinallyturnedpositiveafterseveralyearsofcontraction.
Inadditiontothelabormarketandloan-growthindicators,loweroilpricesanddollarstrengthshould
support U.S. growth. Cheaper oil frees consumer funds previously spent on gasoline and home
heatingfuel.Similarbenefitsaccruetocompaniesthatnowcanenjoyreducedtransportationcosts
(shipping),fuelcosts(especiallymanufacturers),andreducedpackagingcosts(plastics).Astronger
dollar reduces the cost of imports, expanding consumer purchasing power and reducing cost of
goodstobusinessandmanufacturers.Loweroilandastrongercurrency,whilenotbeneficialtoall
sectorsoftheeconomy,effectivelyactformostconsumersandbusinessesasthekindoftaxbreaks
thatCongresswouldfinddifficulttoachieve.
FedPolicy
Where does this all leave the U.S. central bank? The economic conditions we’ve discussed here
seem to empower the Fed to start raising interest rates by mid- 2015. However, policymakers’
median“dot-plot”expectationofa1.13%fedfundsratebyyear-end2015seemsaggressivefor
severalreasons.First,ahistoricallymindedcentralbank’sprimaryconcernwithratehikesistoavoid
a repeat of the 1937 crisis in which higher rates pushed the economy back into recession. This
primary risk, combined with a more dovish Federal Open Market Committee after the departure of
two policy hawks—Richard Fisher, president of the Dallas Federal Reserve Bank, and Philadelphia
Fed president Charles Plosser—should produce a more cautious approach than Fed projections
imply.Second,theinflationdampeningeffectsofloweroilandastrongerdollar(namely,lower-priced
imports) should allow a dovish Fed more leeway in its rate agenda if economic growth slows in
responsetoearlyratehikes.
Third, there are other influences that could compromise U.S. growth. Recession in Japan and slow
growthintheeurozonecouldaffectU.S.exportsaswellasprofitabilityofcompanieswithnon-U.S.
exposure.ThecompetitivenessofU.S.exportersalsoishurtbythedevaluationsofothercurrencies
versusthedollar.TotheextentU.S.exportersrespondbyreducingproductionormovingitoverseas,
U.S. growth will be affected. Similarly, while lower oil helps many companies, for the U.S. energy
industry it will compromise profitability, capital investment, and potentially production. Taken
together, these issues could be sufficient enough to dull the edge of U.S. expansion to the point
whereaslowerraterisebecomesappropriatepolicy.
Thethreatofslowglobalgrowth,theimpactofastrongerdollaronU.S.exporters,andtheeffectof
lower-priced oil on the domestic energy industry suggest that U.S. growth may be unable to
withstand a quick rate rise to 1.13% by year-end 2015.A cumulative rate rise of 0.50% to 0.75%
seems more appropriate, and more likely, owing to the increasing dovishness on the part of
policymakers.
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InvestmentConsequences
Howcouldthesedevelopmentsinfluencetheperformanceoffixed-incomeportfoliosin2015?Evenif
theFedwereabletoraiseratesonlyto0.50%or0.75%,high-quality,interestrate-sensitivedebtwill
beaffectedmorethanlower-qualityeconomicallysensitivesecurities.OncetheFedbeginsitsrateadjustment process, investors are likely to anticipate future moves, pushing yields higher ahead of
theFed’saction.Ratesonlonger-maturity,high-qualitydebtwillnotbeimmune,butwithJapanand
theeurozoneteeteringonthebrinkofrecession,ayieldabove3%onthe10-yearU.S.Treasurynote
seemsdifficulttoachieve.
Currency devaluation, pursued aggressively in Japan, seems likely to spread to the eurozone and
Chinatoavoideconomicdisasterinthoseexport-sensitiveeconomies.Theresultingstrengthinthe
U.S. dollar will continue to attract foreign investment. Fed rate moves will make short-term fixedincomeinvestmentsevenmoreattractive.
Collectively,inaworldstarvedforreliablegrowth,relativelyattractiveyieldandstabilityofcurrency,
theUnitedStates,in2015,appearstoofferanarrayofattractiveinvestmentoptions.Withinfixed
income, convertible securities, high yield, and the lower tiers of investment-grade debt seem
positioned to perform better than lower-coupon, interest rate-sensitive, high-quality securities. The
widening of yield spreads on lower-quality debt toward the end of 2014 should allow a more
attractive income stream than higher-quality issues, as well as an opportunity for an eventual
narrowingofthespreadthathashistoricallycharacterizedU.S.risinginterest-rateenvironment.
Non-U.S. debt will offer selective opportunity, but total returns will be compromised if securities
involvedepreciatingcurrencies.Generally,U.S.dollar-denominatedforeigndebtseemstobeabetter
alternative, subject to the ability for companies and governments to repay their obligations should
thedollarcontinuetoappreciate.Professionalsecurityselectionwillbeanimportantcontributorto
totalreturnofnon-U.S.debtportfolios.Thisisespeciallytrueofemergingmarkets,wheredeclining
commodity prices affect economic fortunes unevenly. Importers of oil, for instance, offer better
prospectsthancountriesreliantonoilastheirmainexport.
How,then,shouldinvestorspositiontheirfixed-incomeportfoliosinthenewyear?Theymaywishto
consider securities that offer higher income, and are sensitive to economic conditions rather than
interest-rate moves. Conservative investors may want to focus their exposure within the United
Statesandtowardhigher-incomealternativeswithless-volatile,shortermaturities.
Fixed-incomeopportunitiesoutsidetheUnitedStatesseempoisedtodivergebasedonthecountryby-countryeffectsoflowcommodityprices,relativecurrencymovements,andtheeffectsofrising
U.S. interest rates. Security selection based on analysis of these variables seems a more
appropriatestrategyfor2015thanadjustingblanketexposurebasedongeographicregionordegree
ofeconomicdevelopment.
The Fed will play an important role in the future of different fixed-income asset classes, but we
believetheU.S.centralbankwillnotbeasaggressiveasitsforecastsimply.TheFed’sactions,and
theperformanceofmanyfixed-incomeinvestments,willbedrivenbytheconsequencesofloweroil,
dollarappreciation,andpersistentbutunexcitingeconomicgrowth.
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ANoteaboutRisk:Thevalueofinvestmentsinfixed-incomesecuritieswillchangeasinterestratesfluctuate
and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall,
and when interest rates fall, prices generally rise. Bonds may also be subject to other types of risk, such as
call, credit, liquidity, interest-rate, and general market risks. High-yield securities, sometimes called junk
bonds,carryincreasedrisksofpricevolatility,illiquidity,andthepossibilityofdefaultinthetimelypaymentof
interestandprincipal.Moreover,thespecificcollateralusedtosecurealoanmaydeclineinvalueorbecome
illiquid,whichwouldadverselyaffecttheloan’svalue.Longer-termdebtsecuritiesareusuallymoresensitive
tointerest-ratechanges;thelongerthematurityofasecurity,thegreatertheeffectachangeininterestrates
islikelytohaveonitsprice.Lower-ratedbondsmaybesubjecttogreaterriskthanhigher-ratedbonds.Foreign
investments generally pose greater risks than domestic investments, including greater price fluctuations and
higher transaction costs. Special risks are inherent in international investing, including those related to
currencyfluctuationsandforeign,political,andeconomicevents.Further,investinginthesecuritiesofissuers
located in certain emerging countries may present a greater risk of loss resulting from problems in security
registrationandcustodyorsubstantialeconomicorpoliticaldisruptions.Noinvestingstrategycanovercome
allmarketvolatilityorguaranteefutureresults.
Forecasts and projections are based on current market conditions and are subject to change without notice.
Projectionsshouldnotbeconsideredaguarantee.
Statements concerning financial market trends are based on current market conditions, which will fluctuate.
Thereisnoguaranteethatmarketswillperforminasimilarmannerundersimilarconditionsinthefuture.
The fed funds rate is the interest rate at which a depository institution lends immediately available funds
(balancesattheFederalReserve)toanotherdepositoryinstitutionovernight.
Grossdomesticproduct(GDP)isthemonetaryvalueofallthefinishedgoodsandservicesproducedwithin
acountry'sbordersinaspecifictimeperiod,thoughGDPisusuallycalculatedonanannualbasis.Itincludes
all of private and public consumption, government outlays, investments and exports less imports that occur
withinadefinedterritory.
Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's
marketprice.
The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating
organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s
creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are
considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). Highyielding,non-investment-gradebonds(junkbonds)involvehigherrisksthaninvestment-gradebonds.Adverse
conditionsmayaffecttheissuer’sabilitytopayinterestandprincipalonthesesecurities.
The opinions in the preceding commentary are as of the date of publication and subject to change based on
subsequentdevelopmentsandmaynotreflecttheviewsofthefirmasawhole.Thismaterialisnotintendedtobe
legalortaxadviceandisnottoberelieduponasaforecast,orresearchorinvestmentadviceregardingaparticular
investmentorthemarketsingeneral,norisitintendedtopredictordepictperformanceofanyinvestment.Investors
should not assume that investments in the securities and/or sectors described were or will be profitable. This
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accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an
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